Question

15. Which of the following statements correctly reflects the developments in the U.S. automobile industry following an interest rate decrease by the Federal Reserve? a. Both equilibrium output and price will increase. b. Both equilibrium output and price will decrease. c. equilibrium output will increase and price may decrease. d. Both equilibrium output and price may increase. e. none of the above statements is correct.

Answer 1

Let interest rate be denoted by i. Changes in i affect output and price through two channels-

i) If i decreases,loans become cheaper and people will demand more of automobiles. Hence,driving up both price and output.

ii) If i decreases, it becomes cheaper for firms to invest and increase production and to hold inventories,hence production will increase. As supply increases,prices will decrease.

Hence, output will definitely increase, whether prices will increase or decrease is ambigous. If demand is greater than supply,then prices will increase and if demand is less than supply,then prices will decrease. Hence, price may or may not decrease. Therefore we will go with option c. equilibrium output will increase and price may decrease.